Cookies need to be enabled to log into SVB.com. Please accept cookies from this site.

We would like to place cookies on your computer to improve the experience of using our website. You may block cookies from this site but parts of the site will not work. To find out more about the cookies we use and how to delete them, see our cookies policy.

Draghi Bombs the Market with No Action on 8/2

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

European Central Bank (ECB) leader Mario Draghi blew his credibility up in dramatic style over the last couple of weeks by first saying he would forcefully do whatever it takes to preserve the euro on July 26 at the London Global Investment Conference — a very public arena to make such a carte blanche promise. In the ensuing week’s European Central Bank policy meeting after many meetings with different European leaders, he announced, “The ECB may undertake outright open market operations of a size adequate to reach its objective.” This would also include action with the use of the ESFS fund and he repeated, “The Euro is irreversible.”

There are a couple of problems with those statements. One, since when have “may” and “forcefully”, words used in the two statements, been compatible? Two, the ECB and the EU can say how much they want the euro to be irreversible, but they have to serve up the actions that get them out of the corner into which they have backed themselves — a corner where they no longer control the outcome of the euro end game.

The markets control the euro’s destiny. Whether it is next week, next month or five years from now economics will determine the end result. The markets trade off of economic influences — some real, some perceived and some that in retrospect seem predictive. Traders manage their positions against these expectations. That’s how they make money. A decline in credibility as described above puts the ECB in a position of weakness vs. the markets. Another way of putting this is the markets have been given the upper hand by the ECB and they are willing to take on the Central Bank.

After the ECB meeting my immediate question was why the world is waiting for the Europeans to do something definitive and constructive. They only bootstrap solutions that hold a dysfunctional system together and nothing changes, including most importantly, their ability to repay any of the mountains of debt they owe. The markets should just sell the euro through the floor. When it gets to parity we can start talking about how under normal circumstances countries with huge debt problems get themselves out of the hole by purposefully devaluing their own currency. In the case of the euro none of the countries has its own currency; they have a shared currency, which is why they have their current problem. If the market devalues the euro for the ECB because they can’t do it themselves, it would create the same situation as if the euro structure were not in place. European goods would be on a 20 percent fire sale to the rest of the world.

The problem arises if the euro zone countries have to import the commodities they use to make new goods. They would have to import the goods and pay a higher price as commodities are priced in U.S. dollars , although it would probably not be the 20 percent increase caused by the currency devaluation. The action of the devaluation would effectively lower the global commodity prices slightly because the markets would factor in the devaluation’s effect as lower demand brings prices down even though goods are priced in dollars. While the commodity price increase will significantly offset the price advantage created by the devaluation, European goods will still be more competitive as their employment cost and the other domestic costs in the production chain will also be lower.

This is where I put my conspiracy theory hat on and ask whether Mario Draghi made the promise and then came up short as a calculated move to enable the markets to take the euro lower. This strategy would help him and the ECB to get the support of the market and the public for a course of action that would not be officially sanctioned. After all, Draghi is getting nowhere with Germany and the Bundesbank, which, adamantly insist that the ECB should not be allowed to buy the sovereign debt of Italy and Spain. In a newspaper interview ECB Council Member and Head of the Belgium Central Bank Luc Coene said, “It makes no sense for the ECB to start financing the debt of Italy and Spain. It will only lead to the ECB taking the whole of their debt onto the ECB’s balance sheet.”

European exporters would earn more as a result of the devaluation. As production rises they pay higher taxes and the government can begin to get its house in order. The debt would have to be restructured. If a significant percentage was moved out to a much longer maturity than scheduled at the moment, the PIIGs would have more breathing room to pay the debt down.

The Maastricht Treaty was the basis for the foundation of the euro and set out the rules under which the euro was established. One of the most important points being that the sovereign debt of any country was not to exceed more than 2 percent of debt to GDP. Interestingly enough, the writing was on the wall as early as eight years ago when it was revealed that France and Germany — who had regaled Italy for not meeting the debt to GDP ratio — were themselves over the 2 percent level.

There are so many different ways the European story can play out. But there are a few pointers to watch out for as it does. The markets have shown us how they react. On news that is seen as positive for the euro, the reaction is a quick knee jerk move higher for the euro and risk assets, only to be followed by the realization that nothing very much has changed and the move reverses as the focus changes from short term to the longer time horizon.

One of the news bytes to which the market reacted was that the Germans would have a referendum to change in the German constitution that prohibits the use of German funds to bailout other countries. The reality is the German people have never had the opportunity to vote on the euro as directly as this. The markets rallied and soon ran out of steam because if the polls are to be believed it is not very likely the German populous would pass such a measure. Before the August holiday, the German constitutional high court said they would rule on the constitutionality of using German funds to buy bonds of the PIIGs on September 12, using the permanent European Stability Fund (ESM) as the pass-through vehicle. The referendum measure was cited as a possible way for the court to add conditions to its ruling as it is currently scheduled. The measure would take time to be enacted and would allow Germany the flexibility in navigating itself through the negotiation process.

The ECB members cannot seem to agree on the guidelines that should be imposed on countries that need funds. The balance between palatable austerity , fiscal responsibility with an attainable end game seem to be no closer and if the market gets the bit between its teeth and runs out of patience with how long the negotiations are taking. Time is a luxury Europe does not have.

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.

Foreign exchange transactions can be highly risky, and losses may occur in short periods of time if there is an adverse movement of exchange rates. Exchange rates can be highly volatile and are impacted by numerous economic, political and social factors, as well as supply and demand and governmental intervention, control and adjustments. Investments in financial instruments carry significant risk, including the possible loss of the principal amount invested. Before entering any foreign exchange transaction, you should obtain advice from your own tax, financial, legal and other advisors, and only make investment decisions on the basis of your own objectives, experience and resources.

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

European Central Bank (ECB) leader Mario Draghi blew his credibility up in dramatic style over the last couple of weeks by first saying he would forcefully do whatever it takes to preserve the euro on July 26 at the London Global Investment Conference — a very public arena to make such a carte blanche promise. In the ensuing week’s European Central Bank policy meeting after many meetings with different European leaders, he announced, “The ECB may undertake outright open market operations of a size adequate to reach its objective.” This would also include action with the use of the ESFS fund and he repeated, “The Euro is irreversible.”

There are a couple of problems with those statements. One, since when have “may” and “forcefully”, words used in the two statements, been compatible? Two, the ECB and the EU can say how much they want the euro to be irreversible, but they have to serve up the actions that get them out of the corner into which they have backed themselves — a corner where they no longer control the outcome of the euro end game.

The markets control the euro’s destiny. Whether it is next week, next month or five years from now economics will determine the end result. The markets trade off of economic influences — some real, some perceived and some that in retrospect seem predictive. Traders manage their positions against these expectations. That’s how they make money. A decline in credibility as described above puts the ECB in a position of weakness vs. the markets. Another way of putting this is the markets have been given the upper hand by the ECB and they are willing to take on the Central Bank.

After the ECB meeting my immediate question was why the world is waiting for the Europeans to do something definitive and constructive. They only bootstrap solutions that hold a dysfunctional system together and nothing changes, including most importantly, their ability to repay any of the mountains of debt they owe. The markets should just sell the...Read More

Policy

About Us

Silicon Valley Bank is registered in England and Wales at 41 Lothbury, London EC2R 7HF, UK under No. FC029579. Silicon Valley Bank is authorised and regulated by the California Department of Business Oversight and the United States Federal Reserve Bank; authorised by the Prudential Regulation Authority with number 577295; and subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. Silicon Valley Bank is a subsidiary of SVB Financial Group, a Delaware corporation and is an affiliate of SVB Financial Group UK Limited. SVB Financial Group UK Ltd is registered in England and Wales at 41 Lothbury, London EC2R 7HF, UK under No. 5572575 and is authorised and regulated by the Financial Conduct Authority, with reference number 446159. SVB Financial Group and its subsidiary Silicon Valley Bank are members of the Federal Reserve System and Silicon Valley Bank is a member of the FDIC.